Thursday, May 26, 2011

Americans Try to Outrun State, Local Tax Hikes

Alan Dlugash is a New York accountant who specializes in high net worth Manhattanites, but lately he's been fielding a lot of calls from clients in neighboring states -- Connecticut and New Jersey.

"The big deal right now is 'how do I change my residency?'" he said. And the reason is almost always the same: High local taxes.

Given the extension of the Bush era federal tax cuts for two years, a cut in Social Security tax this year, and the rise of anti-tax sentiment evidenced in last November's election results, tales of tax migrants may seem out of sync. Just last week, a number of 'we're undertaxed' reports surfaced suggesting that Americans were facing their lowest tax burdens since 1958.

That ignores the idea that just as all politics is local and personal a lot of taxes are too - and in recent years the states and cities have been busy offsetting federal tax cuts with local tax hikes, largely aimed at higher income earners.

Since the beginning of 2009, some 31 states have hiked taxes on everything from income, estates, and investment gains to cigarettes and plastic bags, with annual net increases pushing $50 billion, according to data from the National Conference of State Legislatures. City and county governments have been piling on too, raising sales and property taxes in many areas even as home values drop.

For example, with last week's passage of a two-year, $2.6 billion tax hike, Connecticut - home to much of the hedge fund industry - raised rates on income and investment taxes for the second time in three years.

It had already pushed up the rate for those earning more than $500,000 to 6.5% from 5% in 2009. Now, it has boosted the top rate to 6.7%, raised sales taxes and added an extra luxury tax on items like pricey boats and bracelets.

Earlier this year, Illinois approved a $6.8 billion income tax hike -- pushing its flat tax rate to 5% from 3%. In California, which still doesn't have a budget for the fiscal year which starts on July 1, Governor Jerry Brown is trying to extend a 0.25 percentage point increase, which took the top rate to 10.55% in 2009 but that expired on January 1.

And there could be more local levies to come, as some experts believe states will have to turn to taxes as they face enduring shortfalls and the loss of federal stimulus funds.

All of which means that Dlugash and other accountants are fielding a lot of calls from people who are wondering if there's anything they can do, from decamping temporarily to low-tax Florida, to buying into money-losing tax shelters, just to cut their local and state tax burdens.

"People are not happy about the direction in which all the state and local taxes are going," said Charles Barragato, an accountant and financial adviser with offices in Connecticut and New York. "We're seeing more of a focus on the state tax implications of any plans. More sophisticated clients are looking at trusts."

In 2000, the average U.S. household was paying 9.4% of its income in state and local taxes, according to data from The Tax Foundation, a conservative leaning think tank.

By 2009, the last year for which figures are available, and the year in which the biggest round of recent tax increases were enacted, that had risen to 9.8%.

This increase, though significant, isn't enough to outweigh the Bush tax cuts in 2001. After all, they reduced the top federal income tax rate to 39.6% from 35%.

But the results of the state and local taxing jag are felt disproportionately in affluent areas that already had comparatively high tax rates, such as Dlugash's stomping grounds in and around New York.

In New York City, a particular issue for the financial community and other high net worth taxpayers is the treatment of capital gains as ordinary income, resulting in a 12.85% rate on investment profits on top of the existing 15% federal rate.

That rate on salaries and investment income rose from 10.5% in 2002. Along the way, the state also did away with almost all tax deductions for higher income earners, and also increased state estate taxes.

"RUN OUT OF TOWN"

It means that a Manhattan family earning $400,000 with $50,000 in income from dividends and $150,000 in capital gains would pay $73,669 in state and local taxes in 2010, up 31% from the $61,986 bill they would have faced in 2000, according to calculations done for Reuters by TurboTax.

Furthermore, the 2010 state burden would have triggered an additional $4,264 in federal taxes because of the way state and federal taxes interplay at high brackets. On top of that, they now face property tax increases that have added thousands of dollars - or in some cases even tens of thousands - to their total tax burden.

"If Kansas legislators ever did to their farmers, or Texas did to their oilmen, what New York does to its financial community, they would have been run out of town on a rail," Dlugash said.
It is no wonder that some wealthy New Yorkers find themselves holding on to stocks, bonds and businesses beyond their preferred sell date because they don't want to pay the associated taxes.
That isn't confined to New York. Richard Mandy, a lifetime Maryland resident who built a successful office furniture business, moved to Miami in Florida, where there is no state income tax, specifically for the purpose of selling his business when he was ready to retire.

He guesstimates that the move saved him more than $350,000 in capital gains taxes, enough to pay for his cushy new home. "As long as the (Maryland) Comptroller of the Currency doesn't come after me, I'll be absolutely delighted," he says.

PROPERTY TAX SCOURGE

Real estate taxes have added another big burden for many homeowners, even as they saw the market values of their houses fall. Between 2005 and 2009, property taxes across the U.S. rose to an average 3.0% of income from 2.8%, the Tax Foundation reported. But those wealthier areas showed a disproportionate increase.

During that same period, property taxes went to 8.7% of income from 7.9% in Essex County, New Jersey, where many bankers and professionals who work in Manhattan live.
That means, a resident owning a $1 million house in Montclair, a popular New Jersey town, would pay $36,400 in property taxes now against $25,800 in 2005. There have been similar steep increases in parts of New York state.

Contrast that with the low taxes in some southern states.

In many counties in Louisiana or Alabama, owners of a $1-million home would owe only about $5,000. And, to rub it in, the house would be enormous by comparison with homes in expensive parts of the northeast.

It all means that middle and upper income earners in the northeast can easily pay tens of thousands more in tax than their equivalents in many other states.

We also shouldn't forget that higher earners in high-tax states often get hit with a double whammy when their state tax burden grows.

That is because of an almost unique American invention called the Alternative Minimum Tax. Originally conceived as a way to insure that even the wealthiest share in the national tax burden, it now catches many in the middle class because the government hasn't adjusted the system for inflation.

But it adds insult to injury, hitting those who already pay high state and local taxes hardest by adding those back into the calculation before additional federal tax is imposed.

"It's a big hurt on the middle level of our clients," says Wayne Berkowitz, an accountant with Berdon LLP. "The middle tier is getting whacked by the AMT as state and local taxes go up."
But a lot of this is backward looking you may say. Surely, the anti-tax atmosphere means that there won't be many more hikes, and that spending cuts will be the key to dealing with budget deficits? Meanwhile, some of the state hikes are already scheduled to expire.

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